Investor Gut Feelings
Using your investment intuition!

Why gut feelings? What is a discussion of gut feelings doing in a website on stock value investing? You may well ask!

The reason revolves around the reality that investing in the stock market is a complex process.

It potentially requires the investor to acquire and bring together a large range of information in order to make optimum buying decisions as to the best stock to invest in.

However ...

MORE INFORMATION IS NOT NECESSARILY BETTER!

This became evident to me when I read a book by Gerd Gigerenzer called Gut Feelings: The intelligence of the unconscious.

He argues that gut feelings, or intuition by another name, consist of two components ...

• simple rules of thumb (heuristics), which take advantage of ...
• evolved capacities of the brain (that have developed through thousands of years of experience)

When confronted with complex tasks, we humans invoke rules of thumb that attempt to hit on the
most important information to make decisions - and ignore the rest.

Gigerenzer provides scenarios to demonstrate the benefits of simplicity that rules of thumb offer ...

"In an uncertain world, simple rules of thumb can predict complex phenomena as well as or better than complex rules do"

"Less can be truly more under certain conditions."

I experienced this insight about relying on too much information when I was completing the discussion in this website on stock market screeners.

I was writing about all the things one needs to do before making an investment decision. Then I said to myself at the time - Would anybody do all this before making an investment choice?

More importantly I then thought ... DO I DO ALL THIS BEFORE MAKING AN INVESTMENT DECISION?

The reality is that in some cases I don't. I unconsciously use a rule of thumb, or a heuristic, based on a more limited information set that is not impeded by over-deliberation.

When choosing good stock investments I AUTOMATICALLY eliminate companies I choose not to invest in order to reduce my choice to the remainder.

In some cases, such as (Australian) resources, I limit my choice to two largest multi-national companies from the hundreds of resource stocks that are available.

Using a watch list is one way I, and others, control and limit the amount of information that has to be deal with when making investment decisions.

I hold an additional ten to twenty companies in my watch list of best businesses on top of the ten to twenty that are already in my portfolio.

How does a company get into my watch list?

It does so on the basis of my buying policy, that firstly requires me to dismiss particular types of stocks.

A company in the watch list make it into my portfolio when a significant margin of safety arises for that stock. Namely, when the price of the stock is significantly lower than my estimation of its intrinsic or true value.

Another insight that Gigerenzer provides in his book that relates directly to stock investing is to do with asset allocation.

He asks - "when are investment intuitions (gut feelings) better than optimal?"

He goes on to quote Harry Markowitz who received a Nobel Prize in 1990 for his ground-breaking work in optimal asset allocation.

This work demonstrated that there is an optimal portfolio that maximises return and minimises risk.

However, Gigerenzer asserts that when Markowitz made his own retirement decisions he did not use this prize-winning technique but instead used a simple heuristic, the 1/N rule, namely ...

Allocate your money equally to each of N funds.

Of course, developing rules of thumb (heuristics) that inform our gut feelings and lead to successful investment decisions require us to sort out the 'wheat from the chaff' in the universe of investment information.

Gigerenzer asserts that the average investor using a recognition heuristic, which implies a limited knowledge of investment "brand names", can perform as well, if not better, than advisors who have more complete knowledge.

He describes two studies where partial ignorance, rather than extensive knowledge paid.

In further support of this assertion, he argues that there is little evidence that advisors can predict much better than chance.

And he claims that 70 per cent of (U.S.) mutual funds perform below the market in any year - and the ones that do better are flat out repeating the performance!

While gut feelings work on a limited set of information, or a beneficial degree of ignorance, I would argue that it takes time and experience to discern what this limited critical information is in any investment scenario.

My gut feeling is that there is no substitute for the time and effort required to develop this discernment skill!

However, if I had to choose one piece of information on which to base my decsion to include a stock in my watch list while waiting for the right price to buy it, it would be return on capital employed.

Why? Companies that can operate with a high stable or increasing return on capital over a number of years are most likely those with an enduring economic moat and good management - a winning formula!

Gigerenzer's book provides some interesting insights for the value investor. These insights have assisted me in revealing how I think about my own investment thinking!

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